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Sunday, January 17, 2016

Iran's Crude Oil Flowing To World Markets And U.S. Debt Bubble

The International Atomic Energy Agency (IAEA), the UN's nuclear watchdog, Saturday issued a report confirming Iran's compliance with the July 2015 nuclear agreement between Iran, the U.S. and five world powers. International Atomic Energy Agency Director General Yukiya Amano released the following statement via the IAEA:

Today, I released a report confirming that Iran has completed the necessary preparatory steps to start the implementation of the Joint Comprehensive Plan of Action. The report was submitted to the IAEA Board of Governors and to the United Nations Security Council. ... full statement ...

After the IAEA issued the report confirming Iran's compliance with the nuclear deal, Secretary of State John Kerry signed a waiver lifting Congressional enacted sanctions related to Iran's nuclear program. At the same time, President Barack Obama issued a new executive order to lift sanctions that were enacted under his authority, and the U.N. and EU moved to provide sanctions relief to Iran.

With sanctions lifted, the Iranian oil minister has said his country will immediately begin selling as much of its crude oil onto the world energy market as it can produce to generate cash the country badly needs to help its economy recover from years of sanctions. Unfortunately, Iran rejoins the world energy market just as the world energy market slumps into a deep price depression.

Sanctions background

The UN Security Council passed a number of resolutions imposing sanctions on Iran, following the report by the International Atomic Energy Agency Board of Governors regarding Iran's non-compliance with its safeguards
agreement and the Board's finding that Iran's nuclear activities raised security questions about the intent of its nuclear program. The United States and other countries imposed sanctions on Iran to prevent its further progress in prohibited nuclear activities, as well as to persuade Tehran to address the international community’s concerns about the intent of its nuclear program.

Acting both through the United Nations Security Council and regional or national authorities, the United States, the member states of the European Union, Japan, the Republic of Korea, Canada, Australia, Norway, Switzerland, and others put in place a strong, inter-locking matrix of sanctions measures relating to Iran's nuclear, missile, energy, shipping, transportation, and financial sectors.

As a part of the sanctions regime, oil exports from Iran could not exceed 1 million barrels per day. The sanctions regime not only cut Iran's oil exports from global markets, they also blocked the import of modern crude oil and natural gas drilling production equipment.

Deal to lift sanctions

Iran, the United States and five other world powers in July of 2015 reached a landmark agreement about the future of Iran's nuclear programs, leading to the lifting of that sanction regime. Under the deal, Iran has agreed to forego enrichment of uranium, which world powers feared could be used to make a nuclear weapon. The 100-page-plus nuclear agreement adopted in July - after years of diplomacy and a final, marathon negotiating session by top diplomats - is complex and highly technical in Iran's compliance requirements toward curbing its nuclear program.

Even before the IAEA issued its final report, allowing sanctions to be officially lifted, Iran's Mehr news agency reported that executives from two of the world's largest oil companies, Shell and Total, had arrived in Tehran for talks with the state oil company and tanker company. Those companies are seeking to provide Iran with modern crude oil and natural gas drilling and production technologies and equipment, as well as to partner with Iran to increase shipment of its oil and gas onto world markets.

Global stocks sank sharply on Friday, as the price of oil slipped below $30 a barrel for the first time in 12 years on traders increasing worry more Iranian oil will swamp the market. West Texas Intermediate, the US oil benchmark, fell $2.00 — almost 6 per cent — to $29.13 a barrel by the close of trading Friday. Brent, the European benchmark also closed Friday at a 12-year low of $28.82 a barrel. On Friday, North Dakota "Bakken" crude dropped to $20 per barrel. That’s one-fifth of the price of 2012, at the peak Bakken boom. Bakken producers must sell at a discount because of the region’s limited oil pipelines and the higher cost of alternate shipping methods.

The Global glut of excess crude oil is at the heart of the market tumult, as investors worried demand for oil from China would drop while oil supplies from Iran would grow. Analysts variously estimate from 1 to 2 million barrels of excess oil above demand is already produced, as the world runs out of storage space to hold it, before Iran was allowed to increase oil shipments over 1 million barrels of oil per day. Oil prices have fallen by about 73% in the past 18 months as production supply outstripped demand during that time. Some industry analysts have said, in the medium term, Iran could add as many as 2.5 million barrels of crude oil per day onto the world market, which will keep the price of oil for some time to come.

The International Monetary Fund says the resurgence in Iranian oil exports could further depress crude prices, deepening a market downturn that already has sorely bruised the oil industry. Iran, which has the world’s fourth-largest oil reserves, plans to swiftly ramp up its exports of oil - post sanctions. The Iranian oil minister has said the country will lift exports by 500,000 barrels per day immediately post-sanctions and raise exports by 1 million barrels per day within six months.

During the go-go years of the housing boom, in the early part of this century, the world economy was thriving, demand was indeed soaring, and many analysts were predicting an imminent “peak” in world production followed by significant scarcities. Not surprisingly, Brent prices rose to stratospheric levels, reaching a record $143 per barrel in July 2008. With the failure of Lehman Brothers on September 15th 2008 and the ensuing global economic meltdown, demand for oil evaporated, driving prices down to $34 that December.
Just three years on, in February 2011, it again crossed the $100 threshold, where it generally remained until June 2014.

Even more oil may be on the way

Tentative progress in negotiations between warring factions in Libya, battling for control of oil and export terminals, could unleash another flood. And Saudi Arabia, Kuwait and Iraq continue to maintain a pumping frenzy to grab Asian markets.

The United States is slowly cutting production. Major oil companies have dropped their rig count, and dozens of small businesses have gone bankrupt. But the industry cannot simply flip the switch on big projects, like deepwater production projects in the Gulf of Mexico, that will bring more production on line as they complete. Smaller companies have to keep producing from Fracked shale fields, even at a loss, to service their loans from bank lenders.

Russia and Saudi Arabia—the world’s two biggest oil producers had indicated they aren't pulling back from huge crude output levels that have helped send prices tumbling. Russia produced oil in the fourth quarter of 2015 at levels not seen since the fall of the Soviet Union, pumping an average of 10.74 million barrels a day.

The Saudis have repeatedly affirmed their determination to keep their production level high. Many reasons have been given for the Saudis’ resistance to production cutbacks, including a desire to punish Iran and Russia for their support of the Assad regime in Syria. Iraq accounted for about 4.6% of global output in November, compared with 3.6% a year ago, and promises to further increase production in 2016.

Analysts from Barclays Plc and Societe Generale have said they believe
Iran has accumulated a significant amount of oil in supertankers at
anchor for immediate shipment when sanctions are lifted. Analyzing
satellite data, an Israeli shipping research company Windward reported
last summer Iran had started slowly increasing production last spring,
accumulating oil in terminal storage tanks on supertankers anchored off
its coast. According to the company data from July, 28 Iranian tanker
ships had been transformed into floating storage, which was carrying at
least 51 million barrels of crude oil by that time. Current satellite
tracking data and industry sources say there are between 19 and 24
Iranian Very Large Crude Carriers (VLCCs) fully loaded and waiting to
set sail.

The return of Iran to the oil market with oil already loaded onto tanker
ships for immediate availability means a price war between Saudi Arabia and Iran for Asian customers, says a senior adviser on security of
supply of the Swedish Energy Agency Samuel Sichuk. According to him,
most likely Iran will offer discounts to push its oil into the world
market ahead of other sellers, as did Iraq after a long absence in the
market.

U.S. "Drill Baby Drill" Under Pres. Obama

Domestic U.S. crude production, which had dropped from 7.5 million barrels per day in January 1990 to a mere 5.5 million barrels in January 2010, when it had a sudden resurgence with the development of Hydraulic fracturing, or fracking, oil and drilling technology. By July 2015 oil production reached a stunning 9.6 million barrels per day. Virtually all the added oil came from shale formations exploited using fracking drilling methods in North Dakota and Texas. Production was also increasing in other regions, among other places, deep-offshore fields in the the Gulf of Mexico, the Atlantic Ocean off both Brazil, West Africa, and even war torn Iraq, which were just then coming on line.

At the same time, increased fuel efficiency in the United States, the world’s leading oil consumer, began to have an effect on the global energy picture. At the height of the country’s financial crisis, when the Obama administration bailed out both General Motors and Chrysler, the president forced the major car manufacturers to agree to a tough set of fuel-efficiency standards now noticeably reducing America’s demand for petroleum.

During Pres. Obama's administration, U.S. crude oil production has increased by more than 11 quadrillion British thermal units (Btu), with dramatic fracked oil field growth in Texas and North Dakota. During the fourth quarter of 2015, US domestic oil production leveled off at 9.2 million barrels per day. Natural gas production—largely from the eastern United States—increased by 5 quadrillion Btu (13.9 billion cubic feet per day) over the past six years.

During the seven years of Pres. Obama's administration, U.S. imports of oil and petroleum products from OPEC have fallen to a 28-year low, according to data from the Energy Information Administration. The U.S. is pumping more of its own oil, and relying less on imports than any time since April 1987, while President Ronald Reagan occupied the White House.

Even as the U.S. reduced OPEC imports over the past six years, hydrocarbon production increased by 3 quadrillion Btu in Russia and in Saudi Arabia by 4 quadrillion Btu. OPEC regularly exceeded its 2015 oil production target of 30 million barrels per day. The Organization of the Petroleum Exporting Countries pumped an average of 31.20 million barrels of oil per day in 2015.

As 2015 drew to a close, many in the global energy industry were praying that the price of oil would bounce back from the abyss, restoring the petroleum-centric world of the past half-century. All evidence, however, points to a continuing depression in oil prices in 2016 — one that may, in fact, stretch into the 2020s and beyond. Given the centrality of oil (and oil revenues) in the global power equation, this is bound to translate into a profound shakeup in the political order, with petroleum-producing states from Saudi Arabia to Russia losing both prominence and geopolitical clout.

To put things in perspective, it was not so long ago — in June 2014, to be exact — that Brent crude, the global benchmark for oil, was selling at $115 per barrel and West Texas Crude was sell at $108. Energy analysts then generally assumed the price of oil would remain well over $100 well into the future, and might gradually rise to even more stratospheric levels

Such predictions inspired the giant energy companies to invest hundreds of billions of dollars in what were then termed “unconventional” reserves: Arctic oil, Canadian tar sands, deep offshore reserves, and dense shale formations. It seemed obvious then that whatever the problems with, and the cost of extracting, such energy reserves, sooner or later handsome profits would be made. It mattered little that the break even production costs of some of those unconventional reserves top $50 a barrel, soaring even to $90 per barrel.

In 2014, Goldman Sachs cautioned investors
that the largest new drilling projects needed to earn at least $90 per
barrel to break even. The World Bank says one-third of current oil
production and two-thirds of future reserves could be uneconomical at prices under $60 per barrel.

The end result of all that production is a rising ocean of oil causing oil prices to deflate over the last 18 months to $30 per barrel, and lower. Worse yet, the International Energy Agency (IEA), now forecasts prices might not again reach the $50 to $60 range until the 2020s, or rebound to $85 until 2040. Think of this as the energy equivalent of a monster earthquake — a pricequake — that will doom not just many “unconventional reserve” projects now underway and already producing fields, but some of the over-extended companies (and governments) that own them.

The current rout in oil prices has obvious implications for the giant oil firms and all the ancillary businesses — equipment suppliers, drill-rig operators, shipping companies, caterers, and so on — that depend on them for their existence. It also threatens a profound shift in the geopolitical fortunes of the major energy-producing countries. Many of them, including Nigeria, Saudi Arabia, Russia, and Venezuela, are already experiencing economic and political turmoil as a result.

The oil sector is quickly slipping into the red, from global oil and gas over production and increases in wind and solar energy production, after years of fat fossil fuel profits. World crude oil inventories are estimated to have grown to 2.99 billion barrels by December 2015, up from 2.70 billion barrels at the end of 2014. Analysts forecast excess oil in storage will continue to increase to 3.11 billion barrels by the end of 2016.

Boom To Bust So Quickly

The world's top oil companies are struggling to cope with oil crashing from June 2014 prices of over $110 per barrel to $30 per barrel in the opening weeks of 2016, forcing them to cut spending month after month by cutting thousands of jobs and scrapping oil field development projects.

The lower-for-longer outlook for oil prices took its heaviest toll yet in the third quarter 2015 as oil companies once again reported a dramatic drop in income, with some falling to a loss. With 10 of the top 20 European and North American oil and gas producers having reported third-quarter 2015 results, seven have posted losses. These include Royal Dutch Shell, Italy's Eni and in North America Occidental Petroleum Corp, Anadarko Petroleum Corp, Hess Corp, Suncor and Conoco Phillips.

Over the past year, ExxonMobil and Chevron's
earnings have slumped by more than 50 percent; their stock prices (as
well as those of Shell, ConocoPhillips, and BP) dropped by as much as
one-third in the first eight months of 2015. In July 2015, Standard & Poor's downgraded Shell's credit rating, partly in response to the company's controversial efforts to drill in the Arctic and other pricey endeavors.

Shell, representative of the current state of the oil sector, posted a third-quarter 2015 loss of $7.4 billion, while declaring a massive $8.2 billion charge after halting its controversial exploration in Alaska's Arctic sea and a costly oil sands project in Canada. Overall, the hit from cancelled development projects, "alongside charges for redundancies and restructuring", meant that its exploration and production division lost $8.2 billion. Underlying profits fell 70 per cent from $5.9bn last year to $1.8bn, as revenues plummeted 36 per cent to $68.7bn. The S&P 500 energy sector ended 2015 down 24 percent.

Fourth-quarter earnings for the category are expected to decline nearly 70 percent year over year, according to S&P Capital IQ.

Texas and South Dakota Oil Patch Frackers In For A Rough Ride

In 2014, Goldman Sachs cautioned investors
that the largest new drilling projects needed to earn at least $90 per
barrel to break even. The World Bank says one-third of current oil
production and two-thirds of future reserves could be uneconomical at prices under $60 per barrel.

Exploring for oil and gas in the shale oil patches of Texas and South Dakota, and then developing those new oil
fields to the production stage is extremely expensive using fracking methods. Smaller- and medium- sized oil and gas exploration and production companies needed to borrow billions of dollars of
operating cash to fuel those business operations -- and everyone thought oil prices would stay reliably high to service ad repay those
loans, once oil and gas started to flow.

In August 2015, crude oil price dipped under $50, then below $40 per barrel, the lowest in more than six years. With the price of WTI dropping into the $50 and below in the third-quarter of 2015, some companies, including Sandridge Energy Inc., Energy XXI Ltd. and Halcón
Resources Corp., all paid more than 40% of third-quarter revenue toward
interest payments on their loans, according to S&P Capital IQ. With WTI stuck in the $40's through the fourth-quarter of 2015, an even higher percentage of cash flow will go to service debt.

Turns out, those expectations for ever high and inflating prices only inflated another huge debt bubble and the worst oil price rout since 1986 is beginning to claim victims in the shale oil patch -- and now its every man for himself. The reality is settling in for the oil industry - and Wall Street - that oil will be lower for longer.

Last week, the U.S. Energy Administration Administration forecast the price of the U.S. benchmark West Texas Intermediate, or WTI, to average $38.50 for 2016, down from $51 in the prior month's forecast.

The good news is that as oil prices have declined over the past
year shale basin oil and gas exploration and production companies were able to drastically reduce costs. The average
break even price across some of America's most prolific shale basins
have declined 33-50% thanks to a combination of better technology,
better understanding of shale, and better practices.

A recent survey by Bloomberg Intelligence shows that some of the best wells in South Dakota's Bakken basin can break even at $30 per barrel. But the break even price for most companies is at least $52 to more than $65 per barrel.

"Half of the current [U.S.] producers have no legitimate right to be in a business where the price forecast even in a recovery is going to be between, say, $50, $60. They need $70 oil to survive," senior oil and gas analyst at Oppenheimer & Co. Fadel Gheit told CNBC's "Power Lunch" last week.

Oil patch economics are such that smaller oil producers will go bankrupt, if they stop pumping oil out of the ground to sell, even at prices under $30. That means they are forced to take less for their oil than it costs to produce - what ever price they can get. They'll still go bankrupt on lower oil prices, the low the price of crude, the faster bankruptcy comes, but they can delay that day when the bank forecloses for non-payment of loans producers took to fracIn

While there has been a push to ban fracking over environmental concerns, the invisible hand of an extremely over supplied market appears to be strangling the industry at such low price points, according to the Wall Street Journal.

Much like the housing bubble a decade ago, the signs were all there for anyone to see. Frackers have been able to survive through 2015 because investor over-confidence that oil prices would remain ever above $100, and when oil dropped under $100 the price would quickly rebound, and because of forward price hedging. But those hedges are rapidly expiring and the price of oil is looks to stay closer to $30 than $100 for months to come, if not a year or two.

On one side are the bankers who have been grappling with the plunge in oil prices and the need to shore up billions of dollars in credit extended to the energy industry. On the other are regulators eager to prevent another financial crisis while not knowing what it might be. Caught in the middle are the small- and medium-size exploration and production companies that rely on credit lines that use their energy reserves as collateral.

Regulators are right to be worried. Bankers may only be worried about having to admit losses right now, but they should be more worried about how they are going to cover those losses, later, if not sooner. More than 30 small companies that collectively owe in excess of $13 billion have already filed for bankruptcy protection so far during this downturn, according to law firm Haynes & Boone. Morgan Stanley issued a report describing an environment “worse than 1986″ for energy prices and producers, referring to the last big oil bust that lasted for years. The current downturn is now deeper and longer than each of the five oil-price crashes since 1970, said Martijn Rats, an analyst at the bank.

October 2015 was billed to be a pivotal month in which deeply indebted shale fracking oil and gas companies would see their credit lines cut. Rather than see a wave of bankruptcies ripple through the fracking industry that would force write downs of bad loans, banks were lenient with their underwater fracking borrowers. A Jeffries report said only $450 million in borrowing bases were cut, across more than 20 companies. That amounts to just 2 percent of available credit lines, much lower than the 15 percent reduction expected by many industry analysts.

In other words, banks allowed exploration and production companies to continue to borrowing and go deeper into debt they can't hope to pay off or even service at $30 or $40 or even $50 per barrel oil. That delayed the inevitable day of reckoning - and bursting of the next financial bubble. The possibility of a wave of bankruptcies was put on hold, after banks have been “surprisingly gentle,” as Jeffries put it in their report.

A few, the biggest, the strongest operators with superior assets have locked in oil prices well above $50 a barrel this year through hedges, which serve as a kind of insurance policy against low prices. Even those producers with better balance sheets say they will keep pumping more.

ConocoPhillips and Pioneer Natural Resources Co., two of the most successful shale operators in the U.S., plan to boost production this year.
But most, companies that drilled themselves into a debt hole so deep they cannot escape will be forced to sell assets or declare bankruptcy. And opportunistic firms are waiting for the wave of bankruptcies to arrive. Once debt is wiped out, maybe with a public bailout, oil-and-gas fields will be cheap. The longer the oversupply sticks, depressing prices, the more companies will falter, leaving their assets ripe for picking at a discount.

Projections for losses on energy loans continue to rise broadly, and some banks have started to raise their own forecasts for such losses. In a biannual review by a trio of banking regulators, the value of loans rated as “substandard, doubtful or loss” among oil and gas borrowers almost quintupled to $34.2 billion, up from $6.9 billion in 2014.

With interest rates near zero, investors craved higher returns. So they handed out massive amounts of corporate loans to the energy sector and elsewhere. Junk bonds reached $1.7 trillion over the past five years; about 27 percent of this high-yield debt came from oil companies. Those junk bonds will shake the financial industry, if the frackers bubble bursts, just as the housing bubble burst. Is there more? Oil-industry consultant Mark Harrington says:

Since 2006, an additional $1 trillion of capital expenditures by just 59 companies has been spent on shale drilling and operations, according to oil-and-gas industry site OilPro.com. And another $1 trillion of energy-bond debt has gone on the books, according to the Bank for International Settlements. Energy-company bonds will sell off and create a pall of risk avoidance across all industries.

A staggering $2 trillion of debt was meant to generate a 3-to-1 increase in value. That value today is definitively less than half of what was spent. Over inflated year-end 2015 reserve values and hard-defaulted credit facilities will combine with an absence of private and public equity markets. The contagion through the expanding and loosely regulated derivative market is surely destined for surprises. Leases will be forfeited and meaningful plugging and abandonment liabilities will build. If the company cannot pay, the banks will be forced to do so.

Now, let's take a look at the 2008 credit contraction. There were over inflated values, aggressive and lax lending, deteriorating credit worthiness, an expanding and unregulated derivatives market, and a gross underestimation of lender exposure, coupled with expectations that price increases would cover credit errors.

Sound familiar?

Oh, and home prices dropped 61 percent over three years during that crisis, according to the Case-Shiller Index. Oil prices have declined 69 percent in just two years.
But, there's a very important difference: Houses had a value, albeit only for the dirt in the worst-case scenarios. Uneconomic oil and gas reserves – those that have been deemed to be not economically viable to extract – have zero value and then create further liabilities to plug them up.

Near term, we are going to see devastatingly bad news in energy company 10ks and conference calls. And then comes the recognition that it's even worse than that.

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